States distribute education funds to school districts through a funding formula set forth in state law. Formulas have two distinct parts — the "foundation" (or base) and "categorical" funding. In most states, the foundation amount is designed to cover the basic cost of education while categorical funding programs finance specific tasks such as special education, reduced class size, and summer-school programs.

The basic structure of foundation funding is simple: the state sets a base dollar amount that, in theory, would cover the minimum education needs of one student. Next, a local property tax effort is determined. The state makes up the difference between the amount of revenue generated by the property tax and the amount guaranteed as the foundation.

For example, if the foundation level is set at $1,000 per pupil and the property tax is 30 mills (one mill equals $1 of taxes for every $1,000 of property value) and the school district averages $20,000 of property wealth per pupil — then the district would raise $600 per pupil ($20,000 times .03). The state would then provide the remaining $400 in per pupil aid. If a second district averages $10,000 of property wealth per pupil and levied the 30-mill property tax, it would raise $300 per pupil ($10,000 times .03). The state would then provide the remaining $700 per pupil.

Very often states set the foundation level not by the level of resources necessary to provide a proper education to each student, but by the amount of funds that the state has available at the time. This trend is changing and more states (for example, Ohio, Maryland, and Wyoming) are beginning to use research-driven studies to determine the funding level needed to provide students with an adequate education.

The use of categorical funding varies from state to state. While most states have fewer than a dozen categorical programs, some have over 30. A rise in the use of adequacy studies to drive the development of foundation formulas is causing a decreased reliance on the use of categorical funding. Maryland, for example, revised its funding formula in spring 2002 and eliminated 27 different categorical funds. While reducing categorical funding can provide flexibility to school districts, it also potentially jeopardizes the continued existence of some programs.